Odomirok Etal Financial Reporting

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Financial Reporting Trough theLens of a Property/Casualty Actuary

Kathleen C. Odomirok, FCAS, MAAA

Liam M. McFarlane, FCIA, FCAS

Gareth L. Kennedy, ACAS, MAAA

Justin J. Brenden, FCAS, MAAAErnst & Young LLP

Casualty

Actuarial

Society

Casualty Actuarial Society, 2013


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FINANCIAL REPORTING THROUGH THE LENS OF A PROPERTY/CASUALTY ACTUARY

Foreword

1

FOREWORD

Ernst & Young was retained by the Casualty Actuarial Society (CAS) to write a new text onfinancial reporting and taxation as it affects reserving and statutory reporting for use in the

CAS basic education process. The CAS had two key objectives for this text:

1. Replace a number of readings that existed on the CASSyllabus of Basic Educationas

of 2011 with a single educational publication.

2. Refine the content of the syllabus material to focus on financial accounting and

taxation topics that are of particular relevance to the property/casualty actuary.

The CAS specified that the new text would focus on the learning objectives contained within

the syllabus as of 2011.

This publication has been prepared from an actuarys lens, highlighting those areas of

financial reporting and taxation deemed to be relevant by the CAS Syllabus Committee and

the authors of this text. The learning objectives contained within the 2011 syllabus provided

the underlying direction of the content contained herein. The Exam 6 learning objectives and

examination material may change over time, and thus, the content of this publication may

need to be updated.

This text does not represent the position of Ernst & Young or the authors with respect to

interpretations of accounting or tax guidance. Nor is this text intended to be a substitute for

authoritative accounting guidance issued by the National Association of Insurance

Commissioners (NAIC), American Institute of Certified Public Accountants (AICPA), FinancialAccounting Standards Board (FASB), Governmental Accounting Standards Board (GASB),

Securities and Exchange Commission (SEC), Internal Revenue Service (IRS), Canadian

Institute of Chartered Accountants (CICA), or any other regulatory body. Authoritative

guidance from regulatory bodies trumps the writings contained herein. Furthermore,

accounting standards are continuously evolving. As a result, readers of this text should be

aware that the accounting standards referenced in this publication may have changed since

the time of writing. The CAS may request that this publication be updated to reflect such

changes.

While the authors of this publication have taken reasonable measures to verify references,content and calculations, it is possible that we may have inadvertently missed something. We

would appreciate being informed of any inaccuracies so future editions of this publication may

be corrected.


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Acknowledgements

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ACKNOWLEDGEMENTS

The authors of this publication would like to thank the CAS Syllabus Committee for its review

of this publication and feedback provided. Special thanks goes to Sarah McNair-Grove, Laura

Cali, George Levine, and Michel Trudeau who reviewed the various drafts, and Wendy

Germani who spent countless hours creating and editing the Annual Statement excerpts for

Fictitious Insurance Company. The amount of personal time spent by these individuals

demonstrates their tremendous dedication to the actuarial profession.

The authors would also like to acknowledge those individuals within Ernst & Young who

assisted us by creating certain content, tables and exhibits and performing editorial reviews.

These individuals include John Dawson, Aleksandra Orlova, Cosimo Pantaleo, Doru Pantea,

Anita Park, Kishen Patel, Yan Ren, Christopher Scudellari, Heidi Sullivan and Jay Votta.Particular credit goes to Adam Walter, who created the Risk-Based Capital calculations for

Fictitious Insurance Company and made significant contributions to the Risk-Based Capital

section of this text.

We would also like to thank Dave Heppen, member of the American Academy of Actuaries

Committee on Property and Liability Financial Reporting, for reviewing the sections on the

Statement of Actuarial Opinion and Actuarial Opinion Summary.

Finally, the authors of this text would like to express their deep gratitude to the actuarial

professionals who have invested their time writing publications for the CAS examination

process. Although this publication will serve as a consolidation of many of the papers formerly

on the Exam 6 Syllabus, we acknowledge the significant contributions that those papers have

made in advancing the actuarial profession, as well as the knowledge of the authors of this

text.

In preparing Financial Reporting through the Lens of a Property/Casualty Actuary, we relied

extensively on the following publications and resources:

PUBLICATIONS

2011 Insurance Expense Exhibit.

A.M. Best Company, Bests Key Rating Guide, Property/Casualty, United States & Canada,2010.

Blanchard, Ralph S., Basic Reinsurance Accounting Selected Topics,CAS Exam StudyNote, Arlington, VA: Casualty Actuarial Society, October 2010,http://www.casact.org/library/studynotes/6US_Blanchard_Oct2010.pdf.
http://www.casact.org/library/studynotes/6US_Blanchard_Oct2010.pdfhttp://www.casact.org/library/studynotes/6US_Blanchard_Oct2010.pdfhttp://www.casact.org/library/studynotes/6US_Blanchard_Oct2010.pdf


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Acknowledgements

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Cantin, Claudette, and Phillippe Trahan. Study Note on the Actuarial Evaluation of PremiumLiabilities,Journal of Actuarial Practice, 1999: 7, pp. 5- 72,http://www.casact.org/library/studynotes/cantin7can.pdf.

American Academy of Actuaries Committee on Property and Liability Financial Reporting,Statements of Actuarial Opinion on P&C Loss Reserves, Washington, DC: American Academyof Actuaries, December 2010.

Feldblum, Sholom. Completing and Using Schedule P, 8th Edition, CAS Exam Study Note,Arlington, VA: Casualty Actuarial Society, 2003, 8th Edition, pp 1-92.

Feldblum, Sholom. Computing Taxable Income for Property-Casualty Insurance Companies,CAS Exam Study Note, Arlington, VA: Casualty Actuarial Society, 2007, pp. 1-13,http://www.casact.org/library/studynotes/7U_Feldblum2007.pdf.

Feldblum, Sholom. Federal Income Taxes and Investment Strategy, CAS Exam Study Note,Arlington, VA: Casualty Actuarial Society, 2007, pp. 1-12,http://www.casact.org/library/studynotes/7U_Feldblum_Tax2007.pdf.

Feldblum, Sholom, The Insurance Expense Exhibit and the Allocation of Investment Income,CAS Exam Study Note, Arlington, VA: Casualty Actuarial Society, May 1997,http://www.casact.org/library/studynotes/feldblum7can3.pdf.

Feldblum, Sholom, IRS Loss Reserve Discounting, CAS Exam Study Note,Arlington, VA:Casualty Actuarial Society, 2007, pp. 1-13,http://www.casact.org/library/studynotes/7U_Feldblum_IRS_2007.pdf.

Insurance Accounting and Systems Association, Property-Casualty Insurance Accounting, 8thed., 2003.

MSA Research Inc., MSA Report on Property & Casualty, Canada, 2010.

National Association of Insurance Commissioners,Accounting Practices and ProceduresManual, 2011.

National Association of Insurance Commissioners, NAIC Insurance Regulatory InformationSystem (IRIS) Ratios Manual,2011.

National Association of Insurance Commissioners, Official 2011 NAIC Annual StatementBlanks, Property and Casualty,2011.

National Association of Insurance Commissioners, Property and Casualty Risk-Based CapitalForecasting and Instructions,2011.
http://www.casact.org/library/studynotes/cantin7can.pdfhttp://www.casact.org/library/studynotes/cantin7can.pdfhttp://www.casact.org/library/studynotes/7U_Feldblum2007.pdfhttp://www.casact.org/library/studynotes/7U_Feldblum2007.pdfhttp://www.casact.org/library/studynotes/7U_Feldblum_Tax2007.pdfhttp://www.casact.org/library/studynotes/7U_Feldblum_Tax2007.pdfhttp://www.casact.org/library/studynotes/feldblum7can3.pdfhttp://www.casact.org/library/studynotes/feldblum7can3.pdfhttp://www.casact.org/library/studynotes/7U_Feldblum_IRS_2007.pdfhttp://www.casact.org/library/studynotes/7U_Feldblum_IRS_2007.pdfhttp://www.casact.org/library/studynotes/7U_Feldblum_IRS_2007.pdfhttp://www.casact.org/library/studynotes/feldblum7can3.pdfhttp://www.casact.org/library/studynotes/7U_Feldblum_Tax2007.pdfhttp://www.casact.org/library/studynotes/7U_Feldblum2007.pdfhttp://www.casact.org/library/studynotes/cantin7can.pdf


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Acknowledgements

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Steeneck, Lee R., Commutation of Claims,"CAS Exam Study Note, Arlington, VA: CasualtyActuarial Society, 1998, pp. 1-26,http://www.casact.org/library/studynotes/steeneck6.pdf.

Troxel, Terrie T., and George E. Bouchie, Property-Liability Insurance Accounting and Finance.3rd ed. Malvern, PA: American Institute for Property and Liability Underwriters, 1990.RESOURCES

Actuarial Standards Board, Canada,http://www.actuaries.ca/ASB/index.cfm.

Website of Office of the Superintendent of Financial Institutions,http://www.osfi-bsif.gc.ca/ MCT effective January 1, 2012 The Canadian Annual Statement Blank P&C-1

Website of Canadian Institute of Chartered Accountants,http://www.cica.ca/

Canadian Institute of Actuaries,http://www.actuaries.ca/ Dynamic Capital Adequacy Testing, Educational Note, November 2007
http://www.casact.org/library/studynotes/steeneck6.pdfhttp://www.casact.org/library/studynotes/steeneck6.pdfhttp://www.actuaries.ca/ASB/index.cfmhttp://www.actuaries.ca/ASB/index.cfmhttp://www.actuaries.ca/ASB/index.cfmhttp://www.osfi-bsif.gc.ca/http://www.osfi-bsif.gc.ca/http://www.osfi-bsif.gc.ca/http://www.cica.ca/http://www.cica.ca/http://www.cica.ca/http://www.actuaries.ca/http://www.actuaries.ca/http://www.actuaries.ca/http://www.actuaries.ca/http://www.cica.ca/http://www.osfi-bsif.gc.ca/http://www.actuaries.ca/ASB/index.cfmhttp://www.casact.org/library/studynotes/steeneck6.pdf


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Table of Contents

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TABLE OF CONTENTS

Part I. Introduction .............................................................................................. 7

Chapter 1. Financial Reporting in the Property/Casualty Insurance Industry........................... 7

Chapter 2. Relevance of Financial Reporting to the Actuary .................................................. 11

Chapter 3. Overview of this Publication .................................................................................. 13

Part II. Overview of Basic Accounting Concepts ..................................................17

Introduction to Part II .............................................................................................................. 17

Chapter 4. Primary Financial Statements ................................................................................ 18

Chapter 5. Key Accounting Concepts ...................................................................................... 21

Part III. SAP in the U.S.: Fundamental Aspects of the Annual Statement ..............22

Introduction to Part III ............................................................................................................. 22

Chapter 6. Introduction to Statutory Financial Statements .................................................... 23

Chapter 7. Statutory Balance Sheet: A Measure of Solvency ................................................. 24

Chapter 8. The Statutory Income Statement: Income and Changes to Surplus..................... 40

Chapter 9. Capital and Surplus Account .................................................................................. 55

Chapter 10. Notes to Financial Statements ............................................................................. 60

Chapter 11. General Interrogatories ....................................................................................... 74

Chapter 12. Five-Year Historical Data Exhibit .......................................................................... 81

Chapter 13. Overview of Schedules and Their Purpose .......................................................... 91

Chapter 14. Schedule F .......................................................................................................... 108

Chapter 15. Schedule P ......................................................................................................... 109

Part IV. Statutory Filings to Accompany the Annual Statement ......................... 110

Introduction to Part IV........................................................................................................... 110

Chapter 16. Statement of Actuarial Opinion ......................................................................... 111

Chapter 17. Actuarial Opinion Summary Supplement .......................................................... 122

Chapter 18. Insurance Expense Exhibit ................................................................................. 126

Chapter 19. Risk-Based Capital .............................................................................................. 149

Chapter 20. IRIS Ratios .......................................................................................................... 206


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Table of Contents

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Part V. Financial Health of Property/Casualty Insurance Companies in the U.S. .. 209

Introduction to Part V............................................................................................................ 209

Chapter 21. Measurement Tools ........................................................................................... 210

Part VI. Differences from Statutory to other Financial/Regulatory Reporting

Frameworks in the U.S. .................................................................................... 220

Introduction to Part VI........................................................................................................... 220

Chapter 22. U.S. GAAP, including Additional SEC Reporting ................................................. 221

Chapter 23. Fair Value Under Purchase GAAP ...................................................................... 235

Chapter 24. International Financial Reporting Standards ..................................................... 240

Chapter 25. Solvency II .......................................................................................................... 243

Chapter 26. Taxation in the U.S. ............................................................................................ 248Part VII. Canadian-Specific Reporting ............................................................... 255

Introduction to Part VII.......................................................................................................... 255

Chapter 27. Overview of Financial Reporting in Canada ....................................................... 256

Chapter 28. Canadian Annual Statement .............................................................................. 259

Chapter 29. Financial Health of Property/Casualty Insurance Companies in Canada .......... 275

Part VIII. The Future of SAP ............................................................................. 283

Introduction to Part VIII......................................................................................................... 283

Chapter 30. The Future of Financial Reporting and Solvency Monitoring of Insurance

Companies ............................................................................................................................. 284

Glossary of Terms ............................................................................................ 287

Index ............................................................................................................... 310

Appendices ...................................................................................................... 319


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Part I. Introduction

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PART I. INTRODUCTION

CHAPTER 1. FINANCIAL REPORTING IN THE PROPERTY/CASUALTY INSURANCEINDUSTRY

IMPORTANCE AND OBJECTIVES OF FINANCIAL REPORTING

Financial reporting serves as a means to communicate a companys financial results and

health. Financial reporting is accomplished through a series of financial statements that

consolidate a companys transactions and events into a summarized form under specified

accounting rules. The purpose of these rules is to provide companies with a framework for

measuring and recording transactions and the related revenue, expenses, assets and

liabilities on a consistent basis.

Financial reports enable stakeholders and regulators to track financial performance, compare

a companys performance to others and make informed financial decisions under a set of

common rules. The stakeholders of an insurance company include policyholders, claimants,

investors, directors of the board and company management. The regulators primarily include

state governmental authorities, as we shall see below.

OVERVIEW OF THE BASES OF FINANCIAL REPORTING (STATUTORY, GAAP, IFRS, TAX,

CANADIAN) AND DIFFERENCES IN TERMS OF USE

The accounting standards that govern financial reporting for insurance companies are

numerous and complex. As we write this publication these standards are evolving, and this

evolution is resulting in much debate among industry participants. Regardless, the intent of

accounting standards is to promote a consistent framework for reporting insurance company

transactions such that comparisons of financial performance and health of insurance

companies can be made within the industry.

In the U.S., insurance companies are regulated by the individual state governments within

which they are licensed to transact business. Within each state government there is an

insurance division led by an insurance commissioner, director, superintendent or

administrator (commissioner). The National Association of Insurance Commissioners (NAIC)

serves as an organization of state regulators that facilitates and coordinates governanceacross the U.S. The NAIC itself is not a regulator; regulatory authority remains with the

individual states. Therefore, model laws and regulations established by the NAIC are not law;

individual states have the authority to decide whether to adopt NAIC model laws and

regulations.


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Statutory Accounting Principles (SAP) are accounting principles or practices prescribed or

permitted by an insurers domiciliary state.1Most insurance companies are licensed to

transact business in more than one state. Having to follow the accounting rules and

regulations of each state in which the company is licensed can be cumbersome and result in

inconsistent reporting practices. To minimize the varying complexities of different rules and

facilitate commonality in reporting practices, the NAIC adopted Codification of SAP effective

January 1, 2001. Codification does not prevent individual state regulation but rather

provides a common set of principles that individual states can follow to ease the regulatory

burden on companies and promote consistency.

Statements of Statutory Accounting Principles (SSAP) are published by the NAIC in its

Accounting Practices and Procedures Manual. The manual includes more than 100 SSAPs,

which serve as the basis for preparing and issuing statutory financial statements for

insurance companies in the U.S. in accordance with, or in the absence of, specific statutes or

regulations promulgated by individual states.

From a financial reporting perspective, regulatory oversight by state governments focuses on

insurance company solvency to ensure that policyholders receive the protection they are

entitled to and claimants receive the applicable compensation for damages incurred. SAP and

associated monitoring tools are intended to provide regulators with early warning of

deterioration in an insurance companys financial condition.SAP tends to be conservative in

order to provide that early warning. For example, certain illiquid assets are not admitted

(excluded from the balance sheet) under SAP, despite having economic value.

Generally Accepted Accounting Principles (GAAP) provide another set of common rules under

which publicly traded insurance companies and privately held companies report their financial

transactions and operating results. GAAP does have certain specialized rules for insurance

companies, but unlike SAP, this framework is not built on the principle of conservatism.

Rather, the primary focus of GAAP is the presentation of a companys financial results in a

manner that more closely aligns with the companys financial performance during the period.

Historically, this has been accomplished by matching revenues and expenses. For example,

under GAAP, expenses incurred by an insurance company in conjunction with successful

acquisition of business are deferred to match the earning of associated premium. In contrast,

under SAP, all costs associated with policy acquisition are expensed at the time they are

incurred by the insurance company.

The Securities and Exchange Commission (SEC) is the authoritative body for establishing

accounting and reporting standards for publicly traded companies in the U.S., including

publicly traded insurance companies. As highlighted on the SECs website, The mission of the

U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly and

1NAIC,Accounting Practices and Procedures Manual,Vol I, March 2009, page P-2.


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efficient markets, and facilitate capital formation.2The SEC has assigned the Financial

Accounting Standards Board (FASB) with the responsibility of developing and establishing

GAAP, with the SEC operating in an overall monitoring role. The FASB is the private

organization providing authoritative accounting guidance for nongovernmental entities.

The Governmental Accounting Standards Board (GASB) is the private organization providing

authoritative accounting guidance for the public sector. According to the GASBs website, the

GASB is the independent organization that establishes and improves standards of accounting

and financial reporting for U.S. state and local governments ... the official source of generally

accepted accounting principles (GAAP) for state and local governments.3Although this

publication does not discuss accounting for governmental entities, we note that the

accounting for such entities differs from the accounting for insurance companies. Knowledge

of the GASB as it relates to insurance-related activities of governmental entities is important

for the property/casualty actuary who performs actuarial services for the public sector.

The Internal Revenue Service (IRS) is the U.S. government agency responsible for enforcing

tax laws and collecting taxes. Every business paying taxes in the U.S. must compute taxable

income based on the tax laws passed by Congress and the related regulations issued by the

IRS. For insurance companies, the starting point for taxable income is income determined

under SAP. SAP income is adjusted based on the provisions of the various tax laws and

regulations. While SAP is generally conservative, tax-basis accounting may be more or less

conservative depending on how political and other factors affect tax legislation. While some

adjustments result in a decrease to taxable income (e.g., tax-exempt income), adjustments

specific to the insurance industry tend to focus on the acceleration of income for tax purposes

(e.g., the discounting of loss reserves and the reduction of unearned premiums).

The Canadian Institute of Chartered Accountants is the body in Canada that defines Canadian

Generally Accepted Accounting Principles (CGAAP). At one time, SAP applied to the

preparation of the Annual Return for Canadian-domiciled insurers. However, this is no longer

the case, and the financial statements included in the Annual Return are prepared in

accordance with CGAAP.

Under CGAAP, policy liabilities can be recorded in accordance with accepted actuarial practice

in Canada, which means that the recorded liabilities are discounted to reflect the time value of

money and include a provision for adverse deviation.

International Financial Reporting Standards (IFRS) provide an alternative accounting

framework used by many countries outside the U.S. IFRS are established by the International

2U.S. SEC, The Investors Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates

Capital Formation,http://www.sec.gov/about/whatwedo.shtml,July 30, 2012.3GASB, Facts About GASB,

http://www.gasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=11758240

06278&blobheader=application%2Fpdf,2012.
http://www.sec.gov/about/whatwedo.shtmlhttp://www.sec.gov/about/whatwedo.shtmlhttp://www.sec.gov/about/whatwedo.shtmlhttp://www.gasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175824006278&blobheader=application%2Fpdfhttp://www.gasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175824006278&blobheader=application%2Fpdfhttp://www.gasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175824006278&blobheader=application%2Fpdfhttp://www.gasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175824006278&blobheader=application%2Fpdfhttp://www.gasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175824006278&blobheader=application%2Fpdfhttp://www.sec.gov/about/whatwedo.shtml


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Accounting Standards Board (IASB). There is pressure for the U.S. to replace GAAP with IFRS

for purposes of creating a consistent accounting framework across the globe in response to

the growth of the global economy. However, rather than a direct conversion to IFRS from U.S.

GAAP, the current belief is that there will be a convergence process through joint projects of

the IASB and FASB. It is expected that new standards would be developed and/or there would

be an endorsement process whereby the FASB would evaluate and accept, reject or modify

standards produced by the IASB.

IFRS already affect companies in the U.S. that currently have international subsidiaries or are

subsidiaries of IFRS filers. At the time of the writing of this publication, IFRS 4, which pertains

to the recognition and measurement of insurance contracts, permits insurance companies to

report under the current accounting rules of their local country with slight modifications. An

example of one such modification is requiring companies to establish premium deficiency

reserves, as needed, regardless of local requirements. Given the current lack of a detailed

measurement model under IFRS for insurance contracts, one of the key joint projects of theIASB and the FASB is development of a new accounting standard for insurance contracts. We

will discuss the pending proposals of the IASB and FASB and how they differ from the

measurement of insurance liabilities today.


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CHAPTER 2. RELEVANCE OF FINANCIAL REPORTING TO THE ACTUARY

IMPORTANCE AND OBJECTIVES OF FINANCIAL REPORTING

Actuaries estimate the financial impact of insurable events. As such, actuaries need tounderstand the accounting rules under which the financial impact is being reported. Consider

the actuary providing an estimate of an insurance companys unpaid claims for purposes of

comparison to recorded loss reserves on the companys balance sheet. If the balance sheet is

prepared under Statutory Accounting Principles (SAP), then the loss reserves are recorded on

a net of reinsurance basis. If the companys financialstatements are prepared under

Generally Accepted Accounting Principles (GAAP), then the loss reserves are recorded gross

of reinsurance. For comparison purposes, the actuarial estimate of unpaid claims would need

to be prepared on a net basis for SAP and gross basis for GAAP. The actuary might also

provide an estimate of unpaid claims ceded to the companys reinsurers, for comparison to

the reinsurance recoverable amount recorded as an asset on a GAAP basis.

Actuaries providing estimates of unpaid claims on a SAP basis must also be aware of state

regulations under which the company is recording its loss reserves. For example, while the

National Association of Insurance CommissionersAccounting Practices and Procedures

Manualpermits companies to discount workers compensation reserves on a tabular basis,4

certain states have varying requirements with respect to whether and how the tabular

discount is applied.5For instance, as of December 31, 2011, the state of Montana permitted

tabular discounting but required use of a specific interest rate in the calculation (4%).6

To take this one step further, actuaries issuing Statements of Actuarial Opinion should include

a statement within the opinion stating that the companys recorded loss and loss adjustmentexpense reserves meet the requirements of the insurance laws of (state of domicile).7The

opining actuary is therefore required to read the state regulations and confirm that the

recorded reserves meet the state laws.

The accounting convention is not only important to the reserving actuary for an insurance

company, but also to actuaries who perform other jobs, including but not limited to the

following:

Working with regulators to monitor the financial health of insurance companies

Pricing and designing insurance products, including development of profit margins

4According to page C-3 of the American Academy of Actuaries, 2011 Property/Casualty Loss Reserve Law Manual,

tabular reserves are defined as indemnity reserves that are calculated using discounts determined with reference

to actuarial tables that incorporate interest and contingencies such as mortality, remarriage, inflation, or recovery

from disability applied to a reasonably determinable payment stream. This definition shall not include medical loss

reserves or any loss adjustment expense reserves.5American Academy of Actuaries, Property/Casualty Loss Reserve Law Manual, 2011, page A-6.

6Ibid., page 452.

7NAIC,Annual Statement Instructions Property/Casualty,2011, page 12.


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Determining capital requirements to support the various risks of an insurer

Evaluating risk transfer of reinsurance contracts

Assessing reserve adequacy for non-insurance entities, such as organizations that

self-insure or retain a portion of their property/casualty insurance exposures

Preparing tax returns

Appraising and valuing insurance companies in merger and acquisitions

For each of the above, the result of the work performed will differ depending on the

accounting framework used, illustrating the need for actuaries in different disciplines to be

knowledgeable about the various accounting and financial reporting frameworks.


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CHAPTER 3. OVERVIEW OF THIS PUBLICATION

ROADMAP

This publication begins with an overview of basic accounting concepts (Part II. Overview of BasicAccounting Concepts)and then delves into the fundamental aspects of the statutory Annual

Statement and certain supplemental filings, that provide the means for financial reporting in

the U.S. under Statutory Accounting Principles (SAP) (Part III. SAP in the U.S.: Fundamental

Aspects of the Annual StatementandPart IV. Statutory Filings to Accompany the Annual Statement).

Measurement tools used to evaluate the financial health of a property/casualty insurance

company are discussed inPart V. Financial Health of Property/Casualty Insurance Companies in the

U.S.These tools are particularly important to regulators in monitoring solvency for the

purpose of protecting the stakeholders of an insurance company. We then investigate

differences between statutory reporting and other financial reporting frameworks in the U.S.,

namely Generally Accepted Accounting Principles, International Financial ReportingStandards and tax accounting inPart VI. Differences from Statutory to other Financial/Regulatory

Reporting Frameworks in the U.S.We move on to Canada to provide a discussion of Canadian

accounting principles (Part VII. Canadian-Specific Reporting). The publication closes with a

discussion of the future of SAP and evolution of new accounting frameworks, differentiating

between what is real and what is only in the discussion phase at the time of publication of

this text (Part VIII. The Futureof SAP).

ANNUAL STATEMENTS REFERENCED THROUGHOUT THE PUBLICATION

The Casualty Actuarial Society (CAS) Syllabus Committee and authors of this publication

agreed that it would be helpful for students studying for the CAS exams to be able to rely asmuch as possible on one insurance company throughout the publication to illustrate the major

concepts. For the U.S. examples, the CAS Syllabus Committee has assisted us in creating

excerpts of a 2011 Annual Statement for a fictional insurance company named Fictitious

Insurance Company (Fictitious). The excerpts of this statement are contained in Appendix I of

this publication.

We have relied on the Annual Statement excerpts for Fictitious for the more detailed

examples and calculations. We also referenced the National Association of Insurance

Commissioners 2011 Property and Casualty Annual Statement Blank, which was also included

on the CAS Exam 6 U.S. Syllabus at the time this publication was written. We recommend thateach of these statements be viewed side by side with this publication when reading and

working through examples and following the flow of exhibits, notes, interrogatories, and

schedules within the Annual Statement. We also recommend that the reader review the

Annual Statement for a real company for the current year because the aforementioned

statements were based on 2011.


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For Canada, we have used the 2011 aggregate experience of Canadian insurers as published

on the website of the Office of the Superintendent of Financial Institutions (OSFI). As with the

U.S. chapters, we recommend that the student have this information by his or her side when

reading the Canadian chapters of this publication.

We acknowledge that there may be differences between exhibits within an Annual Statement;

such differences are due to rounding.

BACKGROUND ON FICTITIOUS INSURANCE COMPANY

The authors of this publication felt it important to provide some background information on

Fictitious and describe the landscape in which Fictitious was operating during the time period

covered by its Annual Statement filing (December 31, 2011). This will provide additional

context for students when reading and interpreting the figures contained therein.

Fictitious is a publicly held property/casualty insurance company in the U.S. As displayed inTable 1, approximately one-third of the companys writings in 2011 were in personal lines

markets, with the remainder in commercial markets. Homeowners multiple peril

(homeowners) was the largest single line written in 2011 on a net of reinsurance basis (17%

of net written premium), followed by workers compensation (15% of net written premium)

and other liability occurrence (13% of net written premium). The company wrote business in

all 50 states in the U.S. and was therefore exposed to natural catastrophes and weather-

related events in 2011.


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TABLE 1

Fictitious Insurance CompanyDistribution of 2011 Written Premium (WP) by Line of Business (USD in 000s)

Direct Direct Net NetWP $ WP % WP $ WP%

Line of BusinessPersonal lines

Homeowners multiple peril 4,646 16% 4,555 17%Private passenger auto liability 2,804 10% 2,804 10%Private passenger auto physical damage 1,661 6% 1,665 6%

Subtotal, personal lines 9,111 32% 9,024 34%

Commercial linesFire 3,254 11% 2,484 9%Commercial multiple peril (non-liability portion)

3,243 11% 3,032 11%Commercial multiple peril (liability portion) 1,760 6% 1,645 6%

Workerscompensation 4,394 15% 4,022 15%Other liability occurrence 3,749 13% 3,502 13%Commercial auto liability 2,334 8% 2,250 8%Commercial auto physical damage 651 2% 647 2%Fidelity 138 0% 146 1%

Subtotal, commercial lines 19,523 68% 17,728 66%

Total 28,634 100% 26,752 100%

In terms of the frequency of catastrophe losses incurred by insurance companies worldwide,

2011 was an unprecedented year. Catastrophes ranged from tornadoes in the U.S. to

tsunamis and flooding overseas. According to an article by National Underwriterin early2012, Underwriting losses are expected to total approximately $33.9 billion for 2011, the

second consecutive year of underwriting losses and the third-largest annual underwriting loss

ever behind 2001 ($56.4 billion) and 2002 ($34.3 billion).8The National Underwriterarticle

goes on to say, The industrys combined ratio climbed 6.5 points to 107.5 for 2011.

Catastrophe-related losses accounted for 10.1 points, compared to 4.6 points in 2010.9

As we shall see through examination of the companys 2011 Annual Statement, Fictitious did

not escape the financial impact of the natural catastrophes in the U.S. During 2011, Fictitious

experienced a net loss from underwriting of $2 million, largely due to events including

wildfires in Texas, New Mexico and Arizona; tornadoes in the Midwest and Southeast; the

Halloween Noreaster; and Tropical Storm Lee and Hurricane Irenesimpact on the East

Coast. The companys net loss andloss adjustment expense (LAE) ratio for accident year

2011 was about 10 percentage points higher than that for accident year 2010.

8Gusman, P. 2011 Cats Lead to Largest U.S. P&C Underwriting Loss Since 2002, National Underwriter

PropertyCasualty 360, February 6, 2012.9Ibid.


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When reading this publication and reviewing the 2011 Annual Statement for Fictitious

Insurance Company, note that the U.S. insurance market, including Fictitious, continued to

feel the effects of the financial crisis of 2008. Despite a soft insurance market,10insurance

companies experienced declines in premium volume due to affordability and other economic

issues.11They also experienced declines in investment income due to instability in the

financial markets. The continued soft market conditions also contributed to the increasing

loss and LAE ratio in 2011.

10

A soft market is one where insurance prices are low and therefore insurance is cheaper for the consumer. The

insurance industry tends to observe increasing loss ratios in a soft market because the consumer is paying less in

premiums for the same level of insurance protection.11

For example, workers compensation premium, which is determined based on a rate multiplied by payroll,

declined over the period due to decreases in payroll levels as a result of the economic environment.


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Part II. Overview of Basic Accounting Concepts

17

PART II. OVERVIEW OF BASIC ACCOUNTING CONCEPTS

INTRODUCTION TO PART II

Part II of this publication will provide a detailed discussion on the construction, use and

interpretation of an insurance companysfinancial statements and other financial

information. Before beginning that detailed discussion, we will introduce two important

accounting topics: primary financial statements and key accounting concepts. Both are

recurring topics throughout this publication, and a basic understanding will be helpful to

students.


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CHAPTER 4. PRIMARY FINANCIAL STATEMENTS

PRIMARY FINANCIAL STATEMENTS

Although there are numerous accounting frameworks, they generally rely on a few primaryfinancial statements. Of these, the two most commonly referenced are the balance sheet and

the income statement. Other primary financial statements include the statement of capital

and surplus (or equity) and the statement of cash flow. The financial statements are

accompanied by subsequent pages of notes, which provide additional information that helps

explain balances within the financial statements.

BALANCE SHEET

The balance sheet presents all of a companys assetsand liabilities as of a specific point in

time. Assets are defined as resources obtained or controlled by a company as a result of past

events that have a probable future economic benefit to the company. Liabilities are probablesacrifices of economic benefits arising from present obligations of a company to transfer

assets or provide services to other entities in the future as a result of past events. The

relationship between the assets and the liabilities of a company is important, because it is a

measure of the companys ability to use its assets to fully satisfy its liabilities. The difference

between assets and liabilities is generally referred to as net worth (or equity); in the case of

an insurance company reporting under Statutory Accounting Principles (SAP), this difference

is referred to as statutory surplus (or policyholders surplus).

One unique aspect of insurance companiesbalance sheets is the inherent uncertainty

associated with the estimation of the liability for unpaid claims and claim adjustmentexpenses (loss reserves). While a certain amount of estimation is involved in other industries

accounting, the more significant estimates are generally with respect to asset valuation and

collectability and pale in comparison to the uncertainties involved in estimating loss reserves.

Actuaries typically have an important role in valuing insurance company liabilities and are

therefore critical to the accurate preparation of the balance sheet.

INCOME STATEMENT

While the balance sheet presents the financial balances of a company at a point in time, the

income statement reveals a companys financial results during a specific time period. The

general types of accounts that are used as a means to measure these results are revenue andexpenses. Revenues are inflows or enhancements of assets or settlement of liabilities (or a

combination of both) from delivering goods or services during the specific time period.

Expenses are outflows or other use of assets or incurrence of liabilities (or a combination of

both) from delivering or producing the goods and services that were provided during the

specific time period. The difference between the amount of the revenues and expenses during

the period is referred to as net income if it is positive or net loss if it is negative.


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The nature of the service provided by insurance companies, which is a promise to pay claims

in the future if some specific criteria are met, creates unique accounting challenges.

Insurance accounting standards address how to earn the premiums insurance companies are

paid and how to measure and when to record claim costs resulting from the insurance

coverage. Again, actuaries usually play a significant role in the estimation of the amount and

timing of these future payments and therefore are critical to the accurate preparation of the

income statement. Another important source of revenue for insurance companies is

investment income, which will be discussed inChapter 8. The Statutory Income Statement: Income

and Changes to Surplus.

CAPITAL AND SURPLUS

The statement of capital and surplus reflects certain changes in surplus that are not recorded

in the income statement and reconciles the beginning surplus to the ending surplus for the

reporting period. This statement is similar for insurance companies and for other types ofcompanies; however, there are several items within the statement of capital and surplus, such

as those related to nonadmitted assets and the provision for reinsurance, that are unique to

insurers. These items and others will be discussed inChapter 7. Statutory Balance Sheet: A

Measure of SolvencyandChapter 8. The Statutory Income Statement: Income and Changes to Surplus.

CASH FLOW

The cash flow statement receives less attention but is also important. This financial statement

is necessary because the timing of the receipt or payment of cash for a revenue or expense

does not necessarily coincide with the recognition of that revenue or expense from an income

statement perspective. In other words, even if the cash payment is received sometime beforeor sometime after the good or service is provided, the associated revenue is generally

recognized at the time the good or service is provided. The cash flow statement presents all

operations strictly from a cash perspective.

In other industries, companies face liquidity issues when they cannot collect revenue in cash

on a timely basis, and this type of liquidity issue would be made evident by the statement of

cash flows. An example of this would be a manufacturing company that sold products on

credit but was not able to collect the cash on a timely basis to pay their expenses. For

insurance companies, this specific type of liquidity issue is less likely to occur due to the

collection of premiums at the onset of the policy and the subsequent payment of losses. This

difference in the order of cash receipts and disbursements somewhat diminishes the

importance of cash flow statements for insurance companies. Further, actuaries are not

generally involved in or necessary for the preparation of the cash flow statement, so this

financial statement is not covered in detail in this publication.


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NOTES TO FINANCIAL STATEMENTS

In addition to the four primary financial statements already discussed, another important

element is the notes to financial statements. The notes include quantitative and qualitative

disclosures regarding the significant accounts presented in the financial statements. Thisincludes matters that are relevant or may be relevant to the users of the financial statements.

For instance, the notes will typically describe the basis of accounting used in the preparation

of the financial statements, as well as any important details on specific aspects of the

financial statements that are based on estimates or subject to uncertainty. We will discuss

several of the footnotes to the financial statements that are of specific importance to

actuaries inChapter 10. Notes to Financial Statements.


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CHAPTER 5. KEY ACCOUNTING CONCEPTS

Throughout each major accounting framework, there are several common key concepts.

Understanding these key concepts will be beneficial to anyone who is involved in using or

preparing financial statements because it will allow them to appreciate the purposes of andthe differences between each framework. A few of the most important and relevant concepts

are below.

Liquidation vs. going concern: When preparing financial statements, it is possible to

view the company as either an ongoing business (going concern) or as a run-off of the

current assets and liabilities (liquidation). Either perspective may be appropriate

depending on the user and purpose of the financial statements. For instance, investors

would generally be most interested in the value of a business as a going concern,

whereas regulators may think in terms of a liquidation perspective, given that they are

primarily interested in satisfying policyholder obligations.

Fair value vs. historical cost: There are often multiple possible approaches to valuing a

given asset or liability. The choice of approach is of particular importance when the

value of that asset or liability is uncertain. Recording an asset or liability at fair value

means recording it at a value that it would be bought or sold for in the open market,

while recording at historical cost means valuing it at the original purchase price less

depreciation. In cases where the value of an asset or liability is uncertain, there is a

trade-off between the reliability of the historical cost method (in that it is objectively

verifiable) and accuracy of the fair value approach (in that it is more consistent with

the actual market value).

Principle-based vs. rule-based: Each aspect of any accounting framework is generally

guided by either a principle or a rule. A principle describes a general accounting

approach that must be interpreted and applied, while a rule provides specific

accounting guidance on how something should be done. There is a trade-off because

the rules-based guidance may be easier to understand and to audit, but a principles-

based approach is generally more adaptable to changes in the business environment.


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Part III. SAP in the U.S.: Fundamental Aspects of the Annual Statement

22

PART III. SAP IN THE U.S.: FUNDAMENTAL ASPECTS OF THE ANNUAL

STATEMENT

INTRODUCTION TO PART III

In the U.S., property/casualty insurance companies report their financial results to state

insurance regulators in what is called the Annual Statement. For those who have never used

or seen an Annual Statement, it is an 8.5 x 14 book. The Property/Casualty Annual

Statement is identified by its yellow cover, while the Life Annual Statements cover is blue

(known as the yellow book and blue book, respectively). Both types of Annual Statements are

publicly available documents.

The Annual Statement is developed and maintained by the National Association of Insurance

Commissioners and is often referred to as the Blank.The Blank is the template thatinsurance companies use to report under Statutory Accounting Principles (SAP), and is

uniformly adopted by all states. This allows insurance companies licensed in multiple states to

prepare one Annual Statement for filing with all states. The Annual Statement is accompanied

by NAIC instructions that are generally adopted by all states, though there are instances of

specific differences and exceptions.

The first page in the Annual Statement is the Jurat page, which provides basic information

about the reporting entity, such as name, NAIC code, address, name of preparer and title, and

officers of the reporting entity. The notarized signatures of officers of the reporting entity are

included on this page, attesting to the accuracy of the information contained therein.

Following the Jurat page are the statutory financial statements. The statutory Annual

Statement contains other exhibits and schedules that provide further insight into the

insurance companys statutory financial statements and historical experience. These include

General Interrogatories; Five-Year Historical Data; and Schedules A, B, BA, D, DA, F, P, T and

Y.

InPart III. SAP in the U.S.: Fundamental Aspects of the Annual Statement,we will walk through the

Property/Casualty Annual Statement, beginning with the financial statements, and discuss

the related accounting requirements. We provide examples to illustrate the uses of the Annual

Statement and how certain amounts are calculated and compiled.


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CHAPTER 6. INTRODUCTION TO STATUTORY FINANCIAL STATEMENTS

INTRODUCTION

This chapter focuses on Statutory Accounting Principles (SAP) and specifically discusses thefundamental aspects of the Annual Statement, including the financial statements themselves

(the balance sheet and income statement, for example), as well as the other exhibits and

filings that accompany the Annual Statement (such as various schedules, the Insurance

Expense Exhibit and the Risk-Based Capital calculation).Part V. Financial Health of

Property/Casualty Insurance Companies in the U.Swill discuss how this information can be used to

assess the financial health of an insurance company andPart VI. Differences from Statutory to

other Financial/Regulatory Reporting Frameworks in the U.Swill focus on differences between SAP

and the other financial and relevant regulatory reporting regimes.

SAP AND THE NAIC

The National Association of Insurance Commissioners (NAIC) operates through various

committees that comprise state insurance commissioners and their staff. Through these

committees, the NAIC regularly updates SAP and creates model insurance laws and

regulations that individual states may elect to adopt. While this generally leads to a good deal

of uniformity in insurance regulation, there are still instances of differences between states.

For example, individual states have the ability to permit accounting practices that differ from

NAIC SAP (permitted practices). And, model laws and regulations are not always enacted by

all states exactly as adopted by the NAIC.

It is worth noting that the NAIC may revise the Annual Statement each year, and thesechanges are described on the NAIC website. Some of the examples and exhibits provided in

this section of the publication are based in part on the information provided in the 2011

industry Annual Statements.12

12Accessed via SNL.com by SNL Financial LC.


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CHAPTER 7. STATUTORY BALANCE SHEET: A MEASURE OF SOLVENCY

As previously noted, the primary focus of statutory accounting is to highlight potential

solvency issues (an insurance companys capability to meet its obligations to its policyholders

and creditors). Consequently, the most important aspect of an insurance companys financialstatements to an insurance regulator is the strength of its balance sheet (i.e., the extent to

which its assets are sufficient to meet all liabilities).

RELEVANCE TO ACTUARIES

Solvency and the balance sheet are relevant to the actuary for two primary reasons.

First, actuaries traditionally have some responsibility for the loss and loss adjustment expense

(LAE) reserves, which represent the majority of the liabilities for property/casualty insurance

companies. Actuaries may either participate directly in the reserve-setting process, or they

may assess the reasonableness of the reserves established by company management.Actuaries involved in either of these functions are focused on the liabilities for losses and LAE

on the Liabilities, Surplus and Other Funds page of the Annual Statement (page 3).

Second, actuaries often have a role in determining or assessing the amount of capital that an

insurance company requires to support the risks that it has taken through its business

operations. In the context of statutory accounting, this would be based on an actuarys

understanding of the Risk-Based Capital (RBC) framework to calculate the required capital at

a given point in time (seeChapter 19. Risk-Based Capital). More broadly speaking, actuaries may

evaluate the surplus needs on other bases, including on an economic basis, which is guided by

the insurer meeting some economically defined criteria for solvency. In both of these cases,an actuary who is evaluating an insurance companys capital will need to be familiar withthe

assets and the liabilities on the balance sheet (pages 2 and 3), as well as the risk

characteristics of each of those items.

This chapter will provide an overview of the composition of the two main categories in the

statutory balance sheet:

Assets (page 2)

Liabilities, Surplus and Other Funds (page 3)


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ASSETS13

Assets can be broadly defined as a property, right or claim arising from past events that has

future value. From an individual perspective, we are all accustomed to the concept of owning

financial assets, such as stocks and bonds, and owning real assets, such as a home or vehicle.Insurance companies own various assets in the same way that an individual does, and those

assets are summarized on page 2 of the Annual Statement Blank (the balance sheet). Some of

these assets are consistent with assets of non-insurance entities, and some are specific to

insurance companies.

Table 2 summarizes the major assets held by the U.S. property casualty insurance industry as

of December 31, 2011.14The first column indicates the numerical label for each item, as

presented on page 2 of the Annual Statement. Only the material line items are shown in this

summary.

13In general, this section aligns with Chapter 2 (Assets) of Property Casualty Insurance Accountingby the Insurance

Accounting and Systems Association (IASA). References to other sections in IASA that were previously on the CAS

Syllabus will be included throughout. Readers seeking additional detail may consult with IASA on these topics or

other topics.14

Accessed via SNL.com by SNL Financial LC.


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TABLE 215

Assets: Total U.S. P&C Insurance IndustrySNL Briefing Book U.S. 2011 Statutory Financials, NAIC Format (USD in OOOs)

Line Description Assets% of

TotalNonadmitted

AssetsNet Admitted

Assets% of

Total

1. Bonds 902,605,065 55% 116,731 902,488,334 57%2.1 Preferred stocks 11,685,355 1% 66,292 11,619,064 1%2.2 Common stocks 232,556,368 14% 3,386,260 229,170,621 14%

4. Real estate 10,413,352 1% 42,809 10,370,543 1%5. Cash, cash equivalents and

short-term investment 72,609,565 4% 24,662 72,584,902 5%8. Other invested assets 122,592,988 7% 5,357,863 117,272,227 7%

12. Subtotal, cash and investedassets 1,352,462,693 82% 8,994,617 1,343,505,691 84%

15.1 Uncollected premiums andagents balances 45,078,729 3% 2,434,863 42,643,866 3%

15.2 Deferred premiums and agentsbalances 79,570,809 5% 213,418 79,357,391 5%

16.1 Amounts recoverable fromreinsurers 29,954,875 2% 12,006 29,942,869 2%

18.2 Net deferred tax asset 47,756,959 3% 18,622,680 29,134,278 2%23. Receivables from parent,

subsidiaries and affiliates 11,821,940 1% 583,221 11,238,720 1%25. Aggregate write-ins 34,218,694 2% 16,917,907 17,300,786 1%

Other non-invested assets 44,439,228 3% 6,427,659 38,021,770 2%

Subtotal, non-invested assets 292,841,233 18% 45,211,754 247,639,680 16%

28. Total 1,645,303,926 100% 54,206,371 1,591,145,370 100%

As shown in Table 2, the U.S. property/casualty industry held $1.6 trillion dollars of assets as

of December 31, 2011. The statutory balance sheet makes two broad distinctions regarding

assets held by insurers:

Cash and invested assets vs. non-invested assets: Assets are categorized by this

criterion to identify the proportion of an insurers asset that is readily convertible to

cash. The cash and invested assets are assets that could be readily sold in near term

to meet the insurers liabilities, while the non-invested assets are less liquid. This

distinction is in line with the emphasis that statutory accounting places on solvency.

Rows 1 through 12 on the Assets page include cash and invested assets, while rows13 through 25 include non-invested assets.

15We acknowledge that assets minus nonadmitted assets should equal net admitted assets. However, there are

certain line items in this table where this equation does not hold. We have taken the data as provided from SNL

Financial LC without modification.


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Admitted vs. nonadmitted assets: As shown in Table 2, there are separate columns

that depict the amount of assets that are nonadmitted. These nonadmitted assets,

which represent about 3% of total assets, are not recognized by state insurance

departments in evaluating the solvency of an insurance company for statutory

accounting purposes. The rationale for this exclusion is that those nonadmitted assets

are not readily convertible for use to meet an insurers liabilitiesnowor in the future

and thus would not be reasonable to consider in evaluating a companys solvency.In

many cases nonadmitted assets are determined by formulae established by the

National Association of Insurance Commissioners (NAIC). As shown in Table 2, there

are nonadmitted assets in the cash and invested assets categories and the non-

invested assets categories, though the proportion of nonadmitted assets is much

lower for cash and invested assets. Several common examples of nonadmitted assets

will be discussed in the description of the specific asset classes below (such as certain

uncollected and deferred premiums and agents balances and net deferred tax assets),

which will help to demonstrate this point.

Those distinctions aside, it is clear from Table 2 that the largest asset class for the property

casualty industry in 2011 was bonds, which represented 57% of the industrys total assets,

followed by common stocks, which represented 14% of the industrys total assets.These

statistics have remained relatively consistent over the years. While most actuaries will not

need to have a deep understanding of each of the asset classes on the balance sheet, is it

worthwhile to know a few relevant details on the largest classes to have a fundamental

understanding of the balance sheet.

Bonds (Line 1)

Bonds are securities that pay one or more future interest payments according to a fixed

schedule. The face value of a bond refers to the amount that is to be paid in the final single

payment at the maturity of a bond. When an insurance company purchases a bond, the value

of that bond is recorded as the actual cost, including brokerage and other fees. This purchase

price may be more or less than the face value of the bond.

To the extent that the purchase price is higher (or lower) than the face value of the bond, a

bond premium (or discount) is recorded as a part of the recorded amount. Over the life of the

bond, that bond premium or bond discount will be amortized according to a constant yield

approach. The reason for this amortization is that when the bond ultimately matures, theamortized value will be equal to the face value, eliminating a lump sum gain or loss at the

maturity of the bond.

After the purchase, statutory accounting indicates that bonds be recorded at one of the

following bases:

Amortized cost


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The lower of amortized cost and fair value

The rating the NAICs Security Valuation Office(SVO) assigns to the bond determines the

applicability of the two bases above. The six possible ratings are NAIC 1 through NAIC 6,

which range from the highest quality bonds to bonds in or near default, respectively.Bonds with the two highest ratings (NAIC 1 and 2) are carried at amortized cost, while bonds

with ratings NAIC 3 (medium quality) and below are carried at the lower of amortized cost

or fair value. The amount at which a bond is recorded, following these criteria, is referred to

as the adjusted carrying value.

Schedule D of the Annual Statement provides details on the specific bonds that are held by an

insurance company, including the following:

Type of issuer (e.g., federal, state or corporate)

Maturity (e.g., one year, one year to five years)

NAIC Class (Class 1 through Class 6)

Based on the industry aggregate Annual Statement as of December 31, 2011, insurance

companies bond portfolios were made up of approximately one-third government-sponsored

entity bonds; one-third corporate bonds; and one-third federal, state and local government

bonds. By maturity, about half of bonds held were 5 years to maturity or less, with the

majority of the remainder having maturities between 5 and 10 years. Furthermore,

approximately 86% of bonds held by insurers were in the NAIC Class 1.

Given that bonds are the largest asset class for property casualty insurers, an actuary or

other user of the financial statements who is reviewing the financial health of an insurance

company may benefit from reviewing the detail in Schedule D.

Stocks (Lines 2.1 and 2.2)

As shown in Table 2, approximately 15% of insurers assetswere in common or preferred

stock. Stocks are securities that represent an ownership share in a company. Those

ownership shares are subordinate to bondholders and creditors. Common stock ownership

confers voting privileges and may pay a dividend, though the dividend is not guaranteed.

Preferred stock does not confer voting privileges but usually provides a guarantee on

dividends to be paid, and usually has preference to common stock in the event of liquidation.

At purchase, stocks are valued at cost plus any brokerage or related fees. After purchase,

publicly traded stocks are recorded at fair value, which is based on the market price that is

readily available to the public and which can generally be determined from external pricing

services. If a stock is not publicly traded or a price is not available, the NAICs SVO will

determine a fair value. Preferred stocks are assigned similar NAIC ratings as bonds with six

rating levels, which dictate whether they are valued at amortized cost or fair value based on

the NAIC rating.


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Because stocks represent a relative minority of the assets held by property casualty insurance

companies, and due to the volatility and uncertainty in the value of stocks, an actuary or

other user of the financial statements who is evaluating the financial health of an insurance

company should take note and investigate further if an insurance company has a relatively

larger portion of their assets in stocks, compared to the overall industry.

Real Estate (Line 4)

Three classes of real estate are presented separately on the Assets page of the Annual

Statement:

Properties occupied by the company Properties held for the production of income Properties held for sale

These classes are relatively self-explanatory, though one detail to be aware of is that if a

company occupies less than 50% of a property, it is classified as either a property held for

production of income or a property held for sale (as opposed to a property occupied by the

company). Properties in the first two categories are recorded at depreciated cost, while

properties that are held for sale are recorded at the lower of depreciated cost and fair value.

Details of a companys real estate transactions and holdings are presented in Schedule Aof

the Annual Statement.

Cash, Cash Equivalents and Short-Term Investments (Line 5)

This asset class generally includes assets that are immediately convertible to cash. As of

December 31, 2011, these assets represented nearly 5% of insurers total assets, and

approximately two-thirds of these assets were in short-term investments.

Cash equivalents must have an original maturity of less than three months, and short-term

investments must have an original maturity of one year or less. In the Annual Statement,

details on cash are provided in Schedule E-1, cash equivalents are described in Schedule E-2,

and short-term investments are found in Schedule DA. Further, a reconciliation is made in the

Cash Flow statement showing cash, cash equivalents and short-term investments at the

beginning of the year, adjusted for net cash (inflows minus outflows from operations,

investments, financing and miscellaneous sources) during the year. The result is the amount

of cash, cash equivalents and short-term investments at the end of the year, which is shownin line 5 of the Assets page.

Uncollected and Deferred Premiums and Agents Balances (Lines 15.1 and 15.2)

These two asset classes represent premiums that have been written, but have not yet been

received. Although the names of the asset classes refer to agents balances(or balances

due from policies sold by insurance agents, as intermediaries between the insurance company


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and the policyholder), both asset classes may also include uncollected premiums for policies

sold directly to policyholders.

Uncollected premiums and agents balances include premiums due on or before the financial

statement date, while deferred premiums and agents balances include premiums due afterthe financial statement date. Both classes include installment premiums that meet those

timing criteria as well.

Premiums that are more than 90 days past due from an agent or a direct policyholder are

considered nonadmitted assets. Furthermore, an insurer may determine that agentsbalances

that are 90 days or more overdue are unlikely to be collected (or impaired). In this event

the insurer should establish an allowance for bad debts.

These two classes together represented nearly 10% of the industry assets as of December 31,

2011, highlighting that collectability of these assets is relevant to a companys financial

health and a measure of the efficiency of its collections department. An actuary or other user

of the financial statements who is reviewing the financial health of an insurer may consider

the overall magnitude of a companysuncollected and deferred agentsbalances and the

percentage of agents balances that are nonadmitted. Either one of these metrics could be

benchmarked to the overall industry; a company having a significantly higher portion of its

assets in these two classes relative to the industry would warrant further analysis to

understand the impact to liquidity.

Amounts Recoverable from Reinsurers (Line 16.1)

This asset class reflects amounts that are expected to be recovered from a reinsurer on

losses and LAE that have been paid by the company, but do not include expected reinsurance

recoveries for loss and LAE reserves. The reason that expected recoveries for loss and LAE

reserves are not included is that loss and LAE are already reflected net of reinsurance on the

balance sheet. Additional detail on expected recoveries for both paid amounts and reserves

are included in Schedule F, which will be discussed in detail inChapter 14. Schedule F.The detail

included in Schedule F allows an actuary or other user of the financial statements to assess

the quality and collectability of the reinsurance recoverables.

Net Deferred Tax Assets (Line 18.2)

Deferred tax assets (DTAs) represent expected future tax benefits related to amountspreviously recorded in the statutory financial statements and not expected to be reflected in

the tax return as of the reporting date. They are referred to as netDTAs because they are

recorded net of any deferred tax liabilities (DTLs) that exist. Two common sources of DTAs

relevant to the actuary are the following:

The difference in tax accounting and statutory accounting for loss reserves The carryforward of net operating losses from previous years


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The first source of DTAs is particularly relevant to actuaries. For tax reporting purposes, loss

reserves are discounted when determining pre-tax income. This means that an insurance

company is not able to deduct from taxable income the full amount of losses that are incurred

during a year. Therefore, assuming loss reserves are growing, a companys pre-tax income on

a tax basis is higher than the companys pre-tax income on a statutory basis in the current

year. In the future, as this discounting unwinds, the insurer will get a tax deduction, which will

not be recorded in statutory financial statements because it was already recorded in the year

the reserves were established. The value of this future deduction (35% of the deduction)

represents the DTAs. This asset can be particularly significant for growing companies.

The second source of DTAs of relevance to the actuary (carryforward of net operating losses)

occurs when an insurance company has net operating losses in one financial year and expects

those losses to offset gains in the future, thereby reducing future tax liability.

For any DTA or DTL, an insurer can only record the portion of the asset or liability that isexpected to be realized, based on available evidence. Furthermore, the insurer must perform

an admissibility test to determine the amount of a DTA that can be considered as an admitted

asset.

As shown in Table 2, DTAs were the largest single source of nonadmitted assets at December

31, 2011, representing $18.6 billion of the total $54.2 billion in nonadmitted assets, or just

over 34%.

Receivables from Parent, Subsidiary and Affiliates (Line 23)

Many insurance companies are members of a national or international insurance group or

may be affiliated with other insurance companies that are owned by the same parent

company. These affiliates often share services or resources, such as internal support staff or

third-party vendor agreements. In these cases, receivable balances for these services or

resources exist between the parties. As shown in Table 2, these receivables accounted for

about 1% of assets held by the industry at December 31, 2011. If an individual company had a

significantly larger portion of their assets in the form of receivables, a user of those financial

statements may consider investigating further, as those receivables may not be as liquid or

available as other asset types. More specifically, the user could attempt to ascertain the

specific source of the receivables and the proportion of the receivables that are paid on time.

Other Nonadmitted Assets

In addition to the examples of nonadmitted assets already mentioned (agents balances more

than 90 days overdue and net DTAs that are do not meet the statutory admissibility test),

there are other sources of nonadmitted assets. Several common examples include:

Amounts held of specific types of bonds, stocks, mortgage loans or real estate that are

in excess of limitations that exist in specific states


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Capitalized electronic data processing equipment and software in excess of state-

specific limits for admitted assets

Furniture, equipment and supplies

Balances due from a broker when a security has been sold but the proceeds have not

been received that are still outstanding more than 15 days after settlement

Funds held or deposited with reinsured companies that exceed the associated liabilities

10% of deductibles recoverable on deductible and service-only insurance policies in

excess of collateral specifically held and identifiable on a per policy basis

As previously noted, nonadmitted assets only represented about 3% of the total industry

assets at December 31, 2011. However, due to their importance when measuring solvency,

an actuary should be familiar with the sources of nonadmitted assets. If an actuary or other

user of the financial statements observes that an insurer has a larger proportion of

nonadmitted assets than the industry average, it may be worthwhile to investigate further to

understand the source of those nonadmitted assets because they could be indicative of aproblem with the business.

LIABILITIES AND SURPLUS16

A liability is an obligation that the company must fulfill, based on past events or transactions,

which will require the use of the companys resources. Under the literal definition of solvency,

a company must have assets that are at least equal to its liabilities to remain solvent.

To be prudent and to comply with RBC requirements (seeChapter 19. Risk-Based Capital), most

insurance companies have assets that significantly exceed their liabilities. The amount of this

excess of assets over liabilities is generally referred to as surplus. Surplus can be viewed asthe equity in the business or as the source of protection to the policyholders. These three

amounts follow the relationship shown below:

Assets = Liabilities + Surplus

Or, equivalently,

Assets Liabilities = Surplus

Because the combination of liabilities and surplus are equal to assets, liabilities and surplus

are presented on the same page (page 3) of the Annual Statement. Statutory Accounting

Principles (SAP), the assets reflected in the relationship above, include only admitted assets

because SAP does not allow insurers to take credit for nonadmitted assets in their surplus.

A breakdown of the industry liabilities and surplus amounts (page 3 of the Annual Statement)

by significant account is provided in Table 3 as of December 31, 2011.17

16Aligns with IASA Chapter 5.


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TABLE 3

Liabilities, Surplus and Other Funds: Total U.S. Property/Casualty Insurance IndustrySNL Briefing Book U.S. 2011 Statutory Financials, NAIC Format (USD in 000s)

Line Description Liabilities% ofTotal

1. Losses 496,162,946 31%2. Reinsurance payable on paid loss and loss adjustment expenses 17,442,626 1%3. Loss adjustment expenses 104,532,699 7%5. Other expenses (excluding taxes, licenses and fees) 23,863,600 1%9. Unearned premiums 204,915,762 13%

12. Ceded reinsurance premiums payable 40,200,154 3%13. Funds held under reinsurance treaties 24,144,250 2%16. Provision for reinsurance 2,994,296 0%25. Aggregate write-in for liabilities 42,889,678 3%

Other liabilities 68,994,071 4%

28. Subtotal, liabilities 1,026,139,981 65%

29. Aggregate write-ins for special surplus funds 54,909,820 3%30. Common capital stock 4,536,681 0%34. Gross paid in and contributed surplus 186,691,158 12%35. Unassigned funds 300,443,945 19%

Other surplus and capital 15,512,118 1%

37. Subtotal, surplus as regards policyholders 562,093,722 35%

38. Total 1,591,145,369 100%

First, note that the total amount of liabilities and surplus shown in Table 3 ($1.591 trillion) is

exactly equal to the amount of net admitted assets that were shown in Table 2. This

relationship must be true given the fundamental equation of Assets = Liabilities + Surplus.

The next observation that can be made is that the insurance industry carried liabilities and

surplus on its balance sheet in a ratio of roughly 2 to 1 as of December 31, 2011. On the

surface, this suggests that the industry as a whole had sufficient assets to be able to sustain a

sizeable increase in liabilities (or reduction in asset values) while still maintaining solvency,

due to the current positive difference of assets relative to liabilities.

However, this may not be true at the individual company level, and there are also other risks

that could affect surplus that are not reflected in either the recorded assets or liabilities (such

as catastrophe risk or liquidity risk). An actuary can benchmark a companys ratio of liabilitiesto surplus against the current industry average. Further investigation may be warranted if the

ratio is significantly higher than that of the industry. A review of the companys RBC would be

the next logical step.

17Accessed via SNL.com by SNL Financial LC.


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We can also measure each of the underlying accounts in relation to total liabilities or surplus.

Together, loss and LAE reserves (lines 1 and 3) have historically been the largest liability item

on a property/casualty insurance companys balance sheet. As of December 31, 2011, this

item represented nearly 60% of total industry liabilities. This speaks to the importance of

property/casualty actuaries to the financial reporting process because they are often the

most suited to evaluate and establish those liabilities. The next largest liability class is

unearned premium reserves, which made up approximately 20% of the industry liabilities as of

December 31, 2011. Given actuaries involvement in pricing products, actuariescertainly play

a role in this premium account. To the extent the unearned premium is not adequate to cover

expected future losses, LAE and maintenance expenses, additional liabilities need to be

recorded. Actuaries often play a key role in that analysis.

A brief description of each of the key liabilities and surplus classes is provided below.

Loss and Loss Adjustment Expense Reserves (Lines 1 and 3)

The required basis for loss and LAE reserves under SAP is defined by SSAP 55, Unpaid

Claims, Losses, and Loss Adjustment Expenses. Statements of Statutory Accounting

Principles (SSAP) 55 states that the recorded liabilities for loss and LAE reserves, for each

line of business and for all lines of business in the aggregate, should be based on

managements best estimate (note that this term is not explicitly defined in the accounting

guida

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